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By Peruvemba Satish, CFA - January 2020
Gold prices surged by nearly a third during 2019 to a high of about $1,550 per ounce in early September. Then prices trended downward through the end of the year before returning to that level again in early 2020. Whereas gold prices were historically tied to inflation, recent price moves are now largely influenced by changes in Federal Reserve (Fed) policy. That’s because interest rate cuts lower yields on other perceived “safe-haven” investments that compete with gold for a place in investor portfolios. In addition, the Fed’s decision to cut rates reflects a highly uncertain environment economically, politically, and financially.
In the past, gold prices typically rose during times of high and rising inflation, serving as an inflation hedge. That relationship weakened in the late 1980s and 1990s as we entered a regime of stable inflation, strong growth and sustained declines in interest rates. Starting in the post-2008 financial crisis period, gold became more tied to the Fed’s monetary policy than actual inflation, which remained low across developed economies. Aggressive monetary policies aimed at supporting the post-crisis economy led to a strong rally in gold that lasted until late 2012.
Gold struggled as crisis conditions receded and the Fed tightened monetary policy, but rallied when the Fed was dovish. Since late 2018, global central banks have been lowering interest rates in response to global growth risks and subdued inflation. This increased the prospect of future inflation and lowered the opportunity cost of owning gold.
Gold miner production costs are relatively fixed in the short run. So, gold price increases typically result in proportionally larger gains in gold mining companies’ operating profits. In our own portfolios, we tend to favor gold companies with lower debt and stable income streams, which we believe makes them more resilient to fluctuating economic and market conditions.
In terms of supply-and-demand fundamentals, mine supply was flat year over year through the third quarter of 2019, according to the World Gold Council. At the same time, gold exchange-traded fund (ETF) holdings reached a record high in October.
Higher gold prices come with a tradeoff, however. As gold became more expensive, it weighed on retail demand. Consumer demand for gold jewelry, bar and coins declined as gold prices rose.
Net central bank gold purchases were also down year over year, falling from record-high purchases in the third quarter of 2018. Central banks bought more gold in 2018 than in any calendar year since the 1970s, according to the World Gold Council. The buying spree marked a sea change in central banks’ approach to gold as a reserve asset after decades of net sales.
The development may reflect cracks in the view of the U.S. dollar as the world’s reserve currency and increasing geopolitical tensions. It’s worth noting that Turkey, Russia and China are the leading central bank buyers of gold—countries on the wrong end of U.S. tariffs and sanctions. Markets also price gold in dollars, so a stronger dollar makes gold more expensive for foreign buyers, and vice versa. Yet despite this fact, the recent gold rally happened while the U.S. dollar generally strengthened.
We don’t see an end to political and market uncertainty anytime soon. Therefore, we expect safe-haven demand to support gold’s price in the near term.
We also continue to hold a positive long-term outlook for gold. That’s because central banks are biased toward lower interest rates, even though “real” rates (stated interest rate minus the rate of inflation) are already negative in much of the developed world. Negative real rates and excessive debt levels are typically associated with inflation, against which investors may use gold to hedge.
Nevertheless, gold may be vulnerable to some profit taking in the near term after its strong recent performance. This may be particularly true if the economic and political environment improves significantly.
Find out how we approach gold investing in our portfolios.
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